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November 30, 2012

3 Scenarios for Bonds if Bernanke Leaves: Pioneer’s Wardwell

If Bernanke leaves the Fed, would rates rise? Pioneer's Sam Wardwell explores the implications for fixed-income investors and advisors

What will markets do if Bernanke departs? (Photo: AP)

With President Obama re-elected, there is much talk of Cabinet members and Federal agency chiefs leaving their posts. For advisors, what could be the most significant leave-taking is already in the works: Mary Schapiro will depart the SEC on Dec. 14. However, for many advisors and their clients, and for many investors who have been plowing money into bonds, another significant departure would be if Ben Bernanke were to leave the Fed.

Bernanke’s term as chairman of the Federal Reserve ends on Jan. 31, 2014, but according to a New York Times report last month, “Mr. Bernanke has told close friends that even if Mr. Obama wins, he probably will not stand for re-election.”

Sam Wardwell (right), VP and investment strategist at Pioneer Investments, said in a Nov. 29 blog that when he was asked about the impact of Bernanke being replaced, he saw three scenarios under which rates “might rise significantly.”

Scenario 1: A Change in the Fed’s Basic Approach First, Wardwell believes that Obama would ask Bernanke to stand for a third term as Fed chairman. Were he to decline, however, “Obama is very likely to replace him with another dove,” with current Fed Vice-Chairman Janet Yellen as the leading candidate.

Regardless of who replaces Bernanke, the Fed’s mandate under Humphrey-Hawkins (under which the Fed chairman reports to Congress twice yearly)—to keep both inflation and unemployment low— “still militates for low rates, and will probably do so until the unemployment rate falls far enough,” in Wardwell’s estimation, “well below 7%,” to the point that “’labor’ becomes scarce enough that unit labor costs start to outpace inflation. With that mandate still in place, the bottom line for Wardwell: the risk of the Fed stepping on the brakes in 2013 appears small.”

Wardwell provides a postscript to his conclusion on Scenario 1: “I expect this scenario, if it plays out, to result in an inflationary boom: falling unemployment => rising wages => rising consumer spending => strong GDP => strong profits, etc. In that scenario, stocks should outperform bonds, and corporate spreads should tighten until the Fed steps on the brakes.” What, exactly, would constitute “stepping on the brakes?” It wouldn’t be “raising rates to 1%,” Wardwell believes, but only “when the Fed Funds rate is materially higher than the inflation rate (2%)."

Scenario 2: A Shift in Investor Sentiment

Discussing the “huge” inflows into bond funds by retail investors, Wardwell warns that if “momentum turns sour and redemptions from loss-averse investors (who want income but hate losing principal) accelerate, who will bid on all the bonds money managers are trying to sell?”

Under this scenario, Wardwell says that if “the Fed tightens somewhat sooner than expected because the economy’s OK (or beginning an inflationary boom), stocks will almost certainly be appreciating. Treasury rates may rise, but it’s unlikely to be a quick bond market panic…advisors will preach diversification and adherence to asset allocation models. The real bond bear market won’t start until the Fed becomes more worried about inflation than unemployment and actively tightens (as opposed to simply normalizing rates).”

Scenario 3: A Bond Market Panic

Wardwell says that his “biggest concern as a fiduciary/investor…is that the global bond market (or U.S. retail) loses confidence in the dollar and Treasuries’ safe-haven status” producing a “market panic.” Should a “wave of 'loss of confidence' selling” begin, he worries that the Fed might be unable to stop it, “since further QE would further weaken confidence in the soundness of the dollar.”

He concludes by saying that while there is currently a great focus in the media on the fiscal cliff, “I’m more focused on whether Congress and the President address the deficit and Debt/GDP ratio…if they do, Scenario 3 becomes much less likely; if they don’t….”

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